The Evolution of Second Lien Lending and Its Impact on Mezzanine Capital

Will 2007 Be the Year of Mezzanine Financing?

Second lien loans have enjoyed surging popularity in recent years, while more traditional mezzanine structures have been sidelined. Could rising interest rates and a cooling economy signal an upcoming resurgence for mezzanine financing?

By Cindy Babitt and Beth Laschinger

March 1, 2007

The Evolution of Second Lien Lending & Its Impact on Mezzanine

Second lien loans began emerging in the late 1990s as a mechanism through which senior lenders could provide additional credit to certain borrowers in the context of traditional asset– based loan (ABL) structures. Also referred to as “stretch senior” or “tranche B” loans, second lien loans allowed senior lenders to bridge the gap between the amount of debt supported by ABL guidelines and the needs of the borrower.

While subordinate to the primary senior debt tranche, second lien loans do carry a direct collateral interest in the assets of a borrower, which allowed banks to gain comfort with providing this type of paper on a somewhat limited basis. The limited number of second lien lenders coupled with a conservative senior lending environment kept most second lien loans conservatively structured and well-priced. Most issuers chose second lien debt in response to a specific liquidity challenge.

Over time, however, numerous capital providers, many non–traditional or unregulated entities such as hedge funds and CLOs, began to offer second lien financing. Unencumbered by the strict underwriting guidelines in place at traditional banks, these investors could take a less structured approach to second lien lending and were attracted by the higher yields offered by second lien paper. While they can still be thought of as “gap” financing, today’s second lien loans are really supported by the cash flow or enterprise value of a company.

At the same time, companies increasingly looked to include a second lien loan in their capital structure as a substitute for high–yield debt and its attendant compliance burden or traditional mezzanine financing. Increased competition from new entrants to the market drove down pricing (typically quoted as a spread over a floating base interest rate such as LIBOR) and base interest rates themselves were relatively low, creating an environment where second lien loans presented a lower cost alternative to traditional mezzanine loans, which had long been a company’s primary option to bridge gaps in its capital structure.

As a result, the volume of second lien loans issued increased dramatically, rising from $195 million in 1997 to $28.3 billion in 2006.1 While these figures do include large, broadly syndicated loans, second lien financing has gained prominence even among relatively illiquid middlemarket companies and is now a part of many M&A transactions. In 2003, just 26% of second lien loan volume was used to finance leveraged buyouts or dividend payments, compared to more than 68% by 2005.2

Looking ahead, it is unclear whether or not second lien loan issuance will continue to rise, particularly in the middle market. Three–month LIBOR has risen 15% since this time last year. With spreads for second lien loans averaging 600 to 800 basis points over LIBOR, effective pricing for second lien loans is approximately 11.5% to 13.5%. Spreads in the middle market can be even higher. At the same time, pricing for traditional mezzanine debt has come down due in part to competition from second lien structures and the continued influx of capital into the market. Do these trends suggest that mezzanine financing could be on the rise?

Second Lien Versus Mezzanine

The term “second lien” can be used to mean different things, so it is important to be precise in any transaction as to exactly what is intended. In all cases, the second lien holder’s interests will come behind those of the borrower’s primary creditor. However, this can be accomplished through either lien subordination or payment subordination, or in some cases, a combination of the two.

Generally under lien subordination, which is most common, two or more creditors will have a security interest in the same pool of collateral but will contractually agree to the order in which proceeds from liquidation of the collateral would be distributed. Thus, the first layer of senior debt would be entitled to all the value realized until it has been paid in full, with the second lien lender relying on the residual value.

Lien subordination can also be achieved by assigning specific pools of collateral to each creditor, with the second lien holder typically receiving an interest in the less liquid assets of a company. Payment subordination requires that the second lien creditor grants another creditor a senior right to any payments received, regardless of the source, after the occurrence of some specified event, typically a default.

Mezzanine debt is also subordinated, always ranking junior in right of payment to any senior debt above it. However, it differs from second lien loans in a number of ways. Generally speaking, mezzanine lenders will not receive a direct collateral interest in the assets of a company. Investment decisions are made with an eye to the cash flow potential of a company and its enterprise value. In addition, mezzanine debt typically carries a fixed coupon of 12% to 16%, thereby eliminating uncertainty regarding payment obligations associated with fluctuation in base interest rates.

Also, many mezzanine deals are structured whereby a portion of the interest payment will accrue each quarter rather than be paid in cash. Finally, mezzanine lenders may also be willing to take a portion of their return in the form of a warrant entitling them to a small equity interest in a company. Warrants may help to reduce current interest payments and allow mezzanine lenders to participate in the longer–term success of the company, thereby giving them greater incentive to help a borrower manage through an unexpected downturn than a second lien lender may have.

Other differences between mezzanine and second lien debt include: investment period, prepayment terms and covenant levels. Mezzanine debt is typically viewed as more patient capital, with maturities of six to eight years versus five to six for second lien loans and often no required principal amortization. While second lien loans typically have little or no scheduled principal amortization, they may contain excess cash flow recapture provisions. Second lien loans do generally offer lower penalties for early repayment than those seen with mezzanine structures, although they tend to carry more restrictive financial covenants.

Advantages of Mezzanine Financing

While the cost of mezzanine debt can be more than that of second lien loans (though not necessarily in rising interest rate environment), the majority of mezzanine deals are likely to be entirely unsecured and therefore clearly preferred by senior bank lenders. As a result, it can be possible to increase the amount of senior leverage available, increasing the ratio of senior debt to mezzanine debt and actually lowering the all–in cost of capital. Legal documentation for a mezzanine deal is more standard and less subject to negotiation—basically simpler, quicker and less expensive.

In addition, treatment of mezzanine lenders vis-a-vis senior lenders in the context of a bankruptcy is well established but second lien loans have yet to be broadly addressed by bankruptcy courts because of their relative infancy in the capital markets. The extent to which intercreditor agreements between first and second lien holders will ultimately be enforceable is still an open question. Fears of an economic downturn are prompting bankruptcy attorneys to speculate that the number of Chapter 11 filings in 2007 will grow. As second lien covenants are largely untested in a bankruptcy situation, debtors and issuers may face a long, expensive battle should a workout situation emerge.

What’s Next for Mezzanine?

Mergers and acquisitions, key drivers of capital raising activity, continue to be strong with announced transaction volumes worldwide approaching a record $1.4 trillion in 2006, a 40% increase over the prior year.3 Not only are large numbers of transactions being completed, middle–market companies are being acquired at average cash flow multiples of approximately eight times trailing 12-month EBITDA.4

Private equity firms continue to have significant amounts of capital to invest, so there is still a lot of equity capital chasing deals. At the same time, senior lenders may become more risk averse as interest rates rise and concerns regarding the outlook for continued economic growth mount. Convergence of these trends would imply a continued need for gap financing at a time when rising interest rates may make issuers uneasy about the prospect of taking on additional floating rate debt.

Such an environment could bode well for mezzanine providers. Issuers seeking to build flexibility into their capital structures and a enjoy higher degree of certainty with regard to debt service costs may be inclined to forego second lien loans in favor of a more traditional mezzanine structure. In addition, mezzanine funds can often supply operational and strategic assistance that second–lien lenders may not be willing or able to provide. Many mezzanine firms are equipped to help business owners improve operational issues, seek out and assess acquisitions, and grow organically.

Another avenue of growth for mezzanine could be an increase in demand for non–control or “sponsorless” investments. To the extent that senior or second lien lenders tighten credit in the face of a softening economy, business owners may see valuation multiples decline to the point where selling their companies no longer makes sense. To the extent that they desire a measure of personal liquidity or would like to take advantage of market conditions to acquire competitors, mezzanine debt can be a good choice.

While most mezzanine firms will only support transactions in which a traditional LBO firm is leading a buyout, there are a handful of funds that are comfortable serving as the primary (or only) institutional investor in a company while leaving control in the hands of current stakeholders. Second lien lenders will typically want to see a meaningful equity contribution coming into a company below their position and are less likely to work directly with entrepreneurs to structure transactions such as dividend recapitalizations or intergenerational transfers.

Although the future of second lien and mezzanine debt is unknown, there have been tremendous amounts of both types of capital raised, virtually guaranteeing that both will be abundantly available into the foreseeable future. Mezzanine funds raised $25.1 billion in 2006, up from $4.1 billion in 2005.5 Hedge funds, with net assets in excess of $1.0 trillion and an increasing appetite for both second lien and mezzanine securities, represent another significant source of available capital.6 As discussed, there are many advantages and disadvantages associated with both securities, making it essential that the borrower understand the differences and choose the appropriate security that fits the immediate and long-term plans for its business.

Cindy Babitt is a partner and Beth Laschinger is vice president at Key Principal Partners